Keep Oil Prices, Geopolitical Uncertainty on Radar Screen
Geopolitical Uncertainty in the Middle East, Along with Rising Crude Oil and Gasoline Prices, Could Throw a Monkey Wrench into the Inflation Equation

April 2012

While core consumer-level domestic inflation appears to be trending slightly downward, the specter of prolonged increases in petroleum-related costs — specifically spikes in gasoline prices — could toss a monkey wrench into the Federal Reserve’s timeline for raising rates.

“The decelerating trend of inflation measures is supportive of the Fed’s accommodative stance,” says Asha Bangalore, senior vice president and economist at Northern Trust. “Yet while overall Consumer Price Index (CPI) is trending down, the geopolitical/nuclear situation in Iran suggests that the specter of higher energy prices will remain on the radar screen in the near term.”

The U.S. CPI rose 0.3% in March, (the most-recent data at press time). Gasoline prices, which still remain slightly below their July 2008 record retail peak, gained 1.7% after February’s 6.0% jump. Overall CPI rose 2.7% in the last 12 months, and core CPI, which excludes food and energy, rose 0.2% in March for a year-over-year gain of 2.3%.

Fed Chairman Ben Bernanke, during recent Congressional testimony, noted that the central bank is concerned about increasing gasoline prices but expects only a temporary push up in inflation as a result. “It has a direct effect on inflation and it also is bad for growth because it takes away buying power for households,” he says. “On the other hand, overall inflation is low and stable, so it is really a question of this particular product becoming more expensive to other products.”

“The higher price of gasoline should translate into a jump in profits of oil-producing companies,” Bangalore says. “At the margin, if higher oil prices reduce discretionary consumer spending, profits of oil companies could make their way into the economy through other conduits: increased investment expenditures of oil companies, larger dividends to shareholders of oil firms and buying back of equities.”

From the supply side of the equation, the 2011 Arab Spring led to higher oil prices temporarily in 2011. This time around, the Iran situation is not the only source of supply pressures, as other supply disruption issues, such as pipeline problems and worker strikes, also have contributed to the pop upward in oil and gasoline prices.

“The bottom line is that demand and supply both determine the price of oil. The recent shortage of oil may prove a passing event in 2012 and likely will be overshadowed by soft economic conditions in 2012, particularly in Europe, until world gross domestic product growth gains momentum,” Bangalore says.

Still, a sustained increase in oil prices due to geopolitical tensions is a legitimate risk to bear in mind for the economic outlook of 2012. Tension from Iran’s proposed nuclear program played a significant part in the oil price saga of March. Since then, oil prices have eased somewhat as Iran has planned to negotiate with world powers amid growing international pressure. Economic setbacks in Iran from U.S. and European sanctions and anxiety about the possibility of airstrikes around Iran’s atomic facilities are the reasons Iran has agreed to come to the table. This could be a temporary relief, however, as Iran’s nuclear ambitions cannot easily be put to rest.

“It is difficult for even an economist to ignore the rising risk of some kind of military engagement between Iran and Israel and/or the U.S. in 2012,” says Paul Kasriel, Northern Trust’s chief economist. “If such a military engagement should occur, then the price of crude oil would initially spike because of a real or imagined interruption in the global supply of crude oil. Depending on how long the price of crude oil remained elevated, a global recession could occur. I deem this the biggest downside risk to my otherwise optimistic U.S. economic forecast for 2012 and 2013.”

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